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Philipp ILLEDITSCH
Fall 2012
1/27
Introduction
2/27
Denition
A swap is an agreement between two parties to exchange cash ows at future dates according to certain rules
3/27
Swaps
Forward or futures are used to lock in price at one future date
e.g. price of oil one year from today
Option 2:
enter into swap agreement
Swap is just sequence of forward/futures contracts, combined with borrowing and lending
4/27
5/27
Swap agreement:
sign agreement with counter-party to buy 100,000 barrels in both year 1 and year 2, for price $X /barrel
6/27
Pricing Swap
What are cash ows from swap (in $100, 000)?
long swap Year 0 0 Year 1 S1 X Year 2 S2 X
Year 2 S2 F0,2
F0 , 1 F0 , 2 F0 , 1 F0 , 2
F0,1 X F0 , 2 X S1 X S2 X
7/27
Swap Price
No-arbitrage implies
(F0,1 X ) e r0,1 (F0,2 X ) e 2r0,2 = 0 i.e., X e r0,1 + e 2r0,2 = F0,1 e r0,1 + F0,2 e 2r0,2
8/27
In General
Suppose forward prices of oil are F0,t Then price per barrel of swap covering periods t1 , t2 , . . . , tn is X =
n r0,ti ti F0,ti i =1 e n r0,ti ti i =1 e
Xe r0,ti ti
i =1
e r0,ti ti F0,ti
i =1
Financial Derivatives Fall 2012 9/27
To extent to which forward prices predict spot prices, Utility Inc expects to pay above spot price at date 1, and below spot price at date 2 That is, there is loan hidden in swap price Of course, spot prices might turn out to be dierent But Utility Inc can use swap to construct pure loan How?
10/27
Value of Swap
Value of swap is zero initially Value may change because
futures prices may change interest rates may change swap payments are made
11/27
We will look at plain vanilla interest rates swaps These swaps are an agreement for the exchange of oating rate interest payments and xed rate interest rate payments As of Dec 2011, the Bank of International Settlements estimates a worldwide notional amount outstanding of 403 trillion USD, and a market value of 18 trillion USD
12/27
Example
Suppose BlueChip borrows $1M in a oating rate loan in October 2010, which they expect to repay in 3 years
e.g. they take 1-year loan for $1M , which they plan to roll-over or they take 3-year oating rate loan
13/27
Example cont.
BlueChips resulting net payment is $1M (rLIBOR + 0.25%) + $1M (rx rLIBOR ) = $1M (rx + 0.25%) They have converted 3-year oating-rate loan into a 3-year xed rate loan
14/27
Example cont.
12-month LIBOR rates turn out to be: Oct 2010 Oct 2011 Oct 2012 6% 5% 8%
i.e. if you take 12-month $1,000 loan in Oct 2010 at LIBOR, you must repay (1 + 6%) $1, 000 in Oct 2011.
15/27
Net Payments
Swap payments/receipts
Total
16/27
Net Payments
Oct Interest payments 2010 0 2011 $1M (6% + 0.25%) = $62, 500 2012 $1M (5% + 0.25%) = $52, 500 2013 $1M (8% + 0.25%) = $82, 500 Swap payments/receipts Total 0 0 $1M (7.2% 6%) = $12, 000 $1M (7.2% 5%) = $22, 000 $1M (7.2% 8%) = $8, 000
Floating rate used here is the one 12-months prior to payment date
Financial Derivatives Fall 2012 17/27
BlueChip is xed rate payer LB is oating rate payer Why would somebody prefer xed over oating payments? Why would somebody prefer oating over xed payments?
18/27
swap
$1M rLIBOR10,11 rx
$1M rLIBOR11,12 rx
$1M rLIBOR12,13 rx
19/27
Pricing Swap
We could do this just as before with commodities e.g. LBs cash ow in Oct 2012 is $1M rx rLIBOR11,12
where rLIBOR11,12 is 12-month LIBOR rate from Oct 2011 to Oct 2012
We could then take the present value of certain cash ows and nd the value of rx such that the net present value is zero ...
20/27
21/27
LBs swap
0
x B2010
0
oat +B2010
$1M rLIBOR10,11
$1M rLIBOR11,12
x Let B2010 denote price of xed rate coupon bond in Oct 2010 that matures in Oct 2013 oat Let B2010 denote price of oating rate coupon bond in Oct 2010 that matures in Oct 2013 oat x No arbitrage implies that B2010 = B2010
22/27
That is:
BlueChip sells LB bond that has face value of $1M , and pays coupon rate of rx LB sells BlueChip bond that has face value of $1M , and pays coupon rate equal to LIBOR rate
x oat Choose rx such that B2010 = B2010
Financial Derivatives Fall 2012 23/27
Back to example
oat = $1M Price at maturity is equal to face value; i.e. B2013 oat ? What is B2012
oat B2012 =
oat B2011 =
oat B2010 =
24/27
What is rx?
x oat rx is coupon rate such that B2010 = B2010 = $1M
We have
$1Mrx e 0.06 + $1Mrx e 0.0652 + ($1Mrx + $1M ) e 0.073 = $1M Solving for rx : rx = e 0.06 1 e 0.073 = 7.2% + e 0.0652 + e 0.073
25/27
In General
26/27
Swap has value of zero when it is issued But not at subsequent dates What is value of swap at any time t?
27/27